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By Erik Kobayashi-Solomon | 03-12-2010 04:28 PM

Headwinds Could Blow Red Hat from High Perch

Though it's managed to make a business out of free software, Red Hat is vulnerable to the competition.

Erik Kobayashi-Solomon: Hi, I'm Eric Kobayashi-Solomon, co-editor of Morningstar's Option Investor. And today, it's my great pleasure to welcome Mike Holt, who's a senior analyst on the tech team here at Morningstar. Mike, thanks for coming.

Michael Holt: Thanks for having me.

Kobayashi-Solomon: So, a little bit ago, I wrote an article talking about taking a bearish stance on Red Hat, a company that you cover, using options. And I just want to get a little more color about Red Hat.

As I was starting to write this article, I got worried. I said, these are guys who are selling refrigerators to Eskimos. They're taking free software and selling it to people. Can you explain how this business model works? Why would anyone want to pay for software that's open source that they can get free?

Holt: Sure. I mean, it's a great question. How does a company make money when they give away their product for free? The answer lies in the fact that with enterprise software, the total cost in ownership is a lot more than just the licenses you purchase. It also accounts for the support you need over the life cycle.

Kobayashi-Solomon: So like the maintenance and how to make everything secure and everything.

Holt: Exactly. So, they are giving away the software for free, but they're charging for the subscriptions that entitle you to all that support.

Kobayashi-Solomon: I see. So, one way to think of it, it's kind of like the razor company selling you a razor really cheaply, but then the actual replacement blades are expensive, right?

Holt: Yeah, there's certainly an element of the razor, razor blade model. I think another key part of it, though, is that with Linux, they're not doing all of the R&D themselves. So, if you look at the last report from the Linux Federation, Red Hat only accounted for about 12 percent of the code enhancements to the latest Linux kernel that was released.

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